What is Tax Basis?
To answer that question, let me posit two hypotheticals:
Hypothetical 1: Mark buys one share of Acme Industries stock for $100 on Monday. The following Monday he sells that share for $100.
Hypothetical 2: Judy buys one share of Kramerica Industries for $20 on Monday. On Thursday, Kramerica Industries announces the release of a new bottle that dispenses both ketchup and mustard, and the stock soars. On the following Monday, Judy sells her share of Kramerica Industries for $100.
What tax result? Do both Mark and Judy have $100 of taxable income? Of course not. We know that Mark has no taxable income and Judy has $80 of taxable income? But how do we know that? The answer: Basis!
Basis is the tax concept that ensures amounts are not taxed twice when they should not be. In Mark’s case, he has no real income when he sells the stock. Judy however, does have income. When she sells the Kramerica stock, she realizes the $80 gain.
Basis is what allows us to measure the appropriate gain or income to the seller of property. While we have a sense that Mark should not have had taxable income and Judy should have, without basis we have no way of measuring whether a disposition of property should trigger a taxable gain, loss, or nothing.
Generally, the basis of an asset is its historic cost, plus any capital improvements or additions made to the asset. In the case of a financial asset in a taxable account, basis is simply the purchase price plus reinvested distributions less any nondividend distributions (returns of capital).
Depreciation
Basis serves another function. Business assets are usually subject to a depreciation allowance on the theory that assets waste away from wear and tear over a useful life. The method and time period for depreciating an asset varies based on the asset. Residential real estate is depreciated in a straight line over 27.5 years. Most non-real estate property is depreciated using an accelerated method and over a shorter period. One business asset that never depreciated is land, on the theory that land has an indefinite useful life.
Each asset is depreciated based on its depreciable basis, which is generally historic cost plus capital improvements. For example, if you purchase a fourth floor residential condominium for $1,000,000 and rent it out, each full year it is used in the rental business you divide the $1,000,000 depreciable basis over 27.5 to come up with a depreciation deduction of $36,364, which lowers the taxable income from the rental activity, and may even be currently deductible against other income if the rental property produces a loss. Note that some of the basis may be attributable to land, which is good basis that can be recovered upon a sale, but it cannot be depreciated.
Step-up at Death
The tax code offers a tremendous benefit for those looking to facilitate Second Generation FI. The tax basis of inherited assets is “stepped-up” to the fair market value of the asset on the original owner’s date of death. This means, among other things, it is usually much better to leave an asset to an heir at death rather than to gift that asset to an heir during life. The asset left upon death has a stepped-up asset basis, while the gifted asset only has the original owner’s basis in the hands of the recipient.
I previously wrote an example of how this works:
William lives in a house he purchased in 1970 for $50,000. In 2019 the house is worth $950,000. If William gifts the house to his son Alan in 2019, Alan’s basis in the house is $50,000. However, if William leaves the house to Alan at William’s death, Alan’s basis in the house will be the fair market value of the house at William’s death.
Lastly, in order to qualify for the step-up at death, an asset must be held in a taxable account. Assets held in retirement accounts do not receive a step-up at death.
Tax Loss Harvesting
Basis is what makes tax loss harvesting possible. Picture Joey, who owns Blue Company stock worth $10,000. He purchased the stock a year ago for $13,000. He can sell his Blue Company stock and deduct the $3,000 loss on his tax return, realizing a nice benefit.
Tax loss harvesting is a neat tool in the tax planning tool box. But it’s a fools errand to succumb to the “tyranny of tactics” and arrange one’s portfolio around tax loss harvesting. At most, tax loss harvesting reduces your taxable income in any particular year by $3,000. Over the long run, that is not the way to build wealth and achieve financial freedom.
Sure, play the tax loss harvesting card when the right opportunity arises, but don’t structure your portfolio with dozens of holdings in the hopes you can get a $3,000 loss every year. Rather, structure your portfolio with your ultimate goal in mind, and if toward year-end an opportunity to do some tax loss harvesting arises, pounce on it.
Retirement Accounts
The term “basis” means something a bit different in the context of retirement accounts. Two points: First, it is possible to have basis in a traditional account. Generally this means that nondeductible, or “after-tax” contributions have been made to the account, and thus, in the future when there are taxable distributions a portion of the distribution will be offset by that basis.
Second, the assets inside of a retirement account (including a Roth account) do not have basis to the owner of the account. These assets do have basis, but that basis is never directly accessible to the owner of the account (in the way that depreciable basis or stock basis is accessible to the owner). Importantly, assets inside of a retirement account do not enjoy the step-up in basis at the owner’s death that assets in taxable accounts enjoy.
Conclusion
Tax basis is an important attribute to understand as you do tax planning. In two weeks I will build on this post to discuss in detail important implications of tax basis for those pursuing financial independence.
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This post is for entertainment and educational purposes only. It does not constitute accounting, financial, investment, legal, or tax advice. Please consult with your advisor(s) regarding your personal accounting, financial, investment, legal, and tax matters. Please also refer to the Disclaimer & Warning section found here.